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Dilantha De Silva
Dilantha De Silva
Articles (134)  | Author's Website |

A New Stock Pick of Warren Buffett's for Growth Investors

RH has a few catalysts that will drive the stock higher

January 23, 2020 | About:

The best thing about following legendary investors is they unlock great investment opportunities well before the rest of us. This is one of the reasons why gurus continue to outperform the general investing public consistently. As Peter Lynch says in his book "One Up on Wall Street," analysts are often late to the party. The latest activity summary for Warren Buffett (Trades, Portfolio) on GuruFocus reveals a new name; RH (NYSE:RH).

RH, which was formerly incorporated as Restoration Hardware, has been a stellar transformation story and its shares have delivered an attractive performance since last June.

Even on the back of these gains, shares seem to be an attractive investment considering the massive growth potential of the company, both in the U.S. as well as internationally.

The business

RH is a luxury home furnishings retailer offering a variety of products, including furniture, lighting, textiles, bath-ware and tableware. At the end of the third quarter of 2019, the company operated 70 RH Galleries and 39 outlet stores in 31 states.

The stellar financial performance

If there’s anything that drives stock prices higher, it’s the underlying numbers of a company. RH has been on top of its game in the last decade, growing its revenue in each of the last 10 years.

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The growth in revenue has translated into higher net income as well. Since 2017, RH has reported earnings beats in 11 consecutive quarters, which is indicative of its growth momentum.

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Along with the increase in revenue, the expansion of operating margins helped RH achieve this streak. These metrics have pushed the company into positive free cash flow territory as well. For the 12 months ended Sept. 30, RH reported it generated $287 million in free cash flow. This is in complete contrast to burning cash in prior periods.

The new design galleries

In a bid to attract more customers and to position the company as one of the go-to names for luxury furnishing requirements, RH is replacing its legacy stores with design galleries.

Source: Forbes.

The first one of this kind was opened in 2014, a 70,000-square-foot store in Atlanta with a rooftop restaurant. In a press release, RH wrote:

“We are opening architecturally inspiring and immersive physical experiences that render our products and services more unique and valuable.”

The message is clear: Management believes that targeting the upscale market in the U.S. is the best way forward for RH. So far, the results have been spectacular.

Management believes the addition of restaurants, wine vaults and coffee bars in these luxurious stores will help customers differentiate RH from its competitors. The target market includes households with an annual income of over $200,000, and providing an unmatched shopping experience to this audience seems to be a winning strategy.

Global expansion is on the cards

In the second-quarter earnings call, management confirmed its plan to expand the brand globally, starting with Europe, and shared with analysts that they have identified 10 locations already. In the following quarter, CEO Gary Friedman made the following remarks about this development:

Germany clearly is one of the biggest markets in Europe and France is I'd say the most fashionable and probably has the most influence on taste and style and maybe a brand cache in all of Europe. So our view and we believe the UK will be our biggest market. And again, I think just about rivals France, London and France from just kind of a global view and global awareness, so two very important cities. So we're going to start in the UK. I think we're going to do something completely revolutionary and unique to introduce ourselves into Europe in a way that no retail brand has done before. And we believe it is right to follow that with Paris and with France and make a statement there, especially as this is the center of the fashion world.

And Germany is also on our list. When I articulated in my letter that we have five to seven locations that we're in negotiations on and pretty close to closing quite a few, Germany is right on that list. We're looking at two locations in Germany right now, one in France that would be Paris with two in the UK. And then we're looking at other cities in Europe; Brussels and Madrid, Barcelona, other key cities where it's really the right place to kind of start our brand and position the brand from a design perspective, also looking at Milan because it's a center of taste and style and where really the biggest home show in the world is, the Salone show in Milan.”

Along with the expected economic growth in Europe, the home furnishing industry is projected to grow at slow and steady rates through 2023.

Europe home furnishing industry revenue

Source: Statista.

RH appears to be expanding at the right time, especially considering the progress made in spite of Brexit headwinds, which have proven to be a dark cloud hanging over the economic growth of the U.K. This initiative will certainly unlock many attractive opportunities for the company in the long term and could turn out to be a catalyst that drives the share price higher in the next five years.

The American consumer is stronger than ever

Household disposable income has recovered dramatically from the lows of the financial crisis-era and the continued growth of the U.S. economy will only strengthen this in the future.

Source: Reuters.

Recession fears are softening and the outlook for the next couple of years looks positive as the low interest rate environment is providing a boost to many businesses and consumers. This paints a positive picture for the U.S. furnishing industry as the availability of credit generally leads to a higher level of discretionary spending on home improvements. According to data from Statista, 8.5% of total U.S. households earn more than $200,000 annually, which leaves RH a massive target market in the country.

The membership model reduces promotional costs

RH has also introduced an annual membership that costs $100, allowing members to gain a 25% discount on all full-priced items. This limits the number of annual promotions the company has to conduct to drive sales, and this strategy will likely improve the operating margins significantly in the coming years.

Friedman knows what he is doing

The importance of a skilled manager leading a company cannot be emphasized enough. The company has had a few close calls in the last decade. For instance, in 2015, the share price declined approximately 60% amidst modest net income growth against the stellar performance of its peers. However, RH continued to stick to its long-term plan of becoming a luxury retailer of choice and did not even embrace the growing trend of e-commerce. Even today, many critics accuse the company of not improving its online presence as Amazon (NASDAQ:AMZN) continues to threaten the existence of brick-and-motor stores. In response, Friedman said, “We have a business model that allows for a unique customer experience that cannot be replicated online.”

The numbers have proven that this stance is the correct one for RH, and it’s completely acceptable to go against the grain when it is working to the benefit of the company and its shareholders.

Friedman is one of the most respected executives in the industry, having played a major role in transforming Pottery Barn and Williams-Sonoma (NYSE:WSM) into billion-dollar businesses. Buffett, who has long been an admirer of high-quality managers, might have considered the skillset Friedman brings to the table when pondering his decision to invest in RH.

Valuation: it’s about paying a fair price for a great company

If an investor can buy a great company at an unbelievable price, that’s certainly a bargain. In search of such opportunities, however, one should never undermine the power of investing in solid businesses that are trading at fair prices. That is what Buffett has been doing for decades. RH’s profitability metrics reveal the company is outpacing its peers on all fronts:

Profitability metric

RH

Sector median

Gross profit margin

41.01%

35.97%

EBIT margin

14.59%

7.33%

Net income margin

7.32%

3.83%

Return on capital

15.67%

5.84%

Return on assets

8.22%

3.7%

Source: Reuters.

Considering these metrics, it would be OK to pay a premium for RH shares, which are currently trading at a forward price-earnings ratio of 22.65. The sector median is 19.15. The double-digit growth expected in the next five years will help investors secure attractive returns and the earnings multiple will decline if those numbers are factored into the analysis instead of just the next period. The expected expansion in Europe will be a key driver of growth. As RH becomes a globally trusted name for luxury furnishing products, the share price will only head higher.

Takeaway

RH's performance and prospects helped its shares make their way into Buffett’s portfolio, and investors would benefit from following his lead. The company is in a growth phase and there are multiple catalysts at play, including higher market penetration in the U.S., growth potential internationally and an expansion of margins resulting from reduced marketing expenses.

Disclosure: I do not own any stocks mentioned in this article.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I'm a CFA level 2 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). During my free time, I enjoy reading.

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